Reader Questions: Biweekly mortgage payments and cutting years off of my loan

As my site expands and my readership grows, I will try and answer more specific questions for my readers and create a FAQ section on the site for readers to thumb through if interested. Please, submit your questions to me as well, I will answer them as quick as possible.

Today’s question comes from a friend and a reader Ryan K:

“My mortgage company called me and asked me if I would be interested in signing up for a biweekly mortgage payment plan, they’re telling me I can save thousands in interest and cut years off the life of my loan – what’s the deal, is this something I should look into further?”

First off, Ryan (and my other readers), be wary of any products being “offered” by your mortgage broker that claim to save you thousands of dollars. Quite often, you can accomplish the same thing by simply calling your bank and asking them. In doing this, you can avoid unnecessary fees and other charges that would go right to the mortgage broker for something offered free by your bank. Also, as the old mantra goes “If it sounds too good to be true, it probably is.”

To answer the question though, what they’re telling you with regards to saving money and cutting years off of the life of your loan is quite misleading. They want to make you think that you’re payments will be the same in total and that the frequency of your payments will create savings and lower the life of the loan and associated interest charges. It’s just not true.

Let’s use an example of a mortgage payment of $1000 due every month. If paid as usual, you would pay $12,000 at the end of the year. In going to a bi-weekly payment plan (making a payment every two weeks) rather than making 12 payments per year of $1000, you will be making 26 payments of $500. You will pay off the loan faster because you’re paying more on your loan each year. Instead of having paid $12,000, you will have paid $13,000 at the end of the year.

There’s no question you can save money in the form of interest charges as well as increase your taxable deductions, but you will have to come up with the additional $1,000 per year in mortgage payments to do so.

You can accomplish the same task for free by sending your mortgage payment along with an additional payment to be applied towards principal (make sure your lender allows this, and that you don’t have prepayment penalties).

I caution you to make certain you can make the additional payments if you decide to move to a biweekly payment plan, as you will pay more throughout the year. If you can do it, yes, it’s great. But you’re not saving money by paying more frequently, rather by paying more on the loan period.

What’s your question?

Are you prepared for an earthquake or natural disaster?

Seeing the recent destruction and annihilation in Haiti, Chile, and now Taiwan, it makes sense to review your own disaster preparedness plans. In St. Louis, we’re only 150 or so miles away from a huge fault line ( the New Madrid Fault Line), and honestly, anything could happen at any time. The last time something major happened was about 110 years ago. Before that, about 200 years ago, a major quake on the fault caused the Mississippi to flow backwards, and created Reelfoot lake in TN.

So what can or should we do to ensure we can survive until we can get out of town and or until help arrives? What types of supplies should we have on hand and how can you incorporate this into your everyday living plans so you don’t just do this for a year or two?

• What to do before an earthquake (FEMA)
• What do to during an earthquake (FEMA)
• What to do after an earthquake (FEMA)
• Seven Steps to Earthquake Safety
• Preparedness FAQs

More links to earthquake preparedness information and response agencies

How much rent or house payment can you afford and still live comfortably?

You must decide between a couple of places, the cost is only a couple of hundred different a month and one place is so much bigger. Should you spend the extra money for the extra space or not? Will you end up putting yourself into a bind down the road if you face unexpected bills? This is often a question faced by many people who are moving out on their own for their first time and or buying their first home. Banks have guidelines as to how much money they would be willing to lend you based upon your current earning power and other criteria, but as we’ve seen that hasn’t worked out so well for the banks and many borrowers. Along the same lines, some renters are required to pass certain criteria to qualify for renting. Predatory lending and variable ARMs on loans were partly the culprit for the current economic crisis, and banks sacrificed short term profits at the expense of long term sustainability, but we’ll save that talk for another day, it will get us nowhere fast.

So how much money should you spend when looking at housing or when deciding which apartment to rent? Below, I will make it easier for you to devise a smart plan for yourself, so you don’t have to count on someone else telling you a magical debt to income ratio you should abide by.

Step 1: Determine how much money you take home after taxes.

This should be a fairly easy task, how much money are you taking home, not grossing? Look at your paycheck and sum all paychecks for the month. Take into account how often you’re paid. Some months there will be four weeks, while others there will be five. If you’re paid monthly, you know you will be paid the same amount. Some folks are paid bi-monthly, and it works out the same way. However, those folks paid weekly may have fluctuations in their monthly take home pay and should take this into consideration.

Step 2: Calculate your monthly expenditures that are not housing or utility related.

Calculate how much money you will spend on a monthly basis on items such as food, gas to get to work, bus or taxi fare, clothes, car insurance, renters insurance, cell phone, and so on. If you’ve got credit card bills and other bills include these here too. Don’t forget about spending money for entertainment either.

Step 3: Calculate your monthly expenditure related to housing and utilities for each of your new options.

While non housing goods are probably going to be fairly stable (with the exception of gasoline), you must calculate how much your utilities will cost for each option. Ask the current owners or renters or landlords what the bills for each place run each month. A place twice as big will likely cost twice to heat and cool, while water maybe constant. Don’t forget about cable, internet, trash, and other utilities like your phone.

Step 4: Determine how much money you should be saving and investing.

You must pay yourself and save and invest in your future. If you’re not calculating saving at least 10% of your pay (and have an emergency fund equal to living expenses for how long it will take you to find a job if you lose yours – you’re setting yourself up for failure otherwise) you are saying you don’t care about your own future, and want to work for the rest of your life for money, instead of having money work for you.

Step 5: Combine the numbers and see which option makes cents.

Here’s an example of a 22 year old kid (we’ll call him Freddy) that makes $30,000 per year, paid weekly, and he’s planning on moving out of his parents house at the end of December.

Freddy’s After Tax Pay = $462 per week. ($30,000 less 20% taxes = $24,000 per year after tax, you can calculate this by taking $30,000 times .8 or $30,000 times .2 = $6,000, then take $30,000 less $6,000 = $24,000) ($24,000 divided by 52 weeks = $462 per week).

This means in January, a five week month, Freddy takes home about $2310. While in February, Freddy only takes in $1848. It’s important to take this into account as you can see it’s a big difference.

Let’s look at those two months, Jan. and Feb.:

Freddy is considering renting two different places Option A and Option B, one Option A costs $750 per month, and Option B costs $1000 but is twice the size. He really wants the second place but is not sure he can afford it or not.

For Jan. and Feb Freddy estimates the two different options to determine what makes sense:

Clearly, you can see why it’s important to do this type of analysis. You don’t know what is the best option until you crunch the numbers. It wouldn’t make sense to take on more than you can afford in option B. Freddy wouldn’t be able to cover his bills more less savings goals in February with option B, even though he could it in Jan.

In general, it doesn’t make sense to back yourself into having 0 dollars left over at month end. What if your car breaks down and or you have to buy a gift for someone. I would suggest you leave an additional cushion of around 10% to cover unexpected costs that may come up. After you’ve gotten comfortable doing this for a year or two and you’re certain you can manage your finances properly you can take more risk in leaving a cushion, perhaps by then you will have built a couple of emergency funds to cover potential unemployment and or other financial emergencies like car repairs.

Hope this helps!

What would it take to become fully self sufficient?

Wake-up, shower, go to work, drive home, eat dinner, spend limited time with kids and wife. Rinse, repeat. I did everything that I was told I should do (I got my bachelors and Masters degree and a great job), and in all accounts I’m doing well and can provide for my (large) family (with help from friends and family for sure). But honestly, it’s not a very fulfilling or fun life for anyone. Maybe life is not supposed to fun, and I simply have false expectations, but I can’t shake these thoughts from my head. The pressure in failing in the corporate world seems all too real. But how can I change this situation? Is there a viable plan to get me where I want to be in the very near future? Will I even be happier if I am able to truly get out of the rat race? What will it take to do so? What are the implications on my children and their schooling? Will my wife even go for it?

I treasure the rare times I get to spend with my kids and wife that are truly not time restricted. I feel like I’m watching the kids grow-up without my being there to see it. Fortunately, my wife can stay home and raise them, so I do take some comfort in knowing that. Loverboy sang the words “Everybody’s working for the weekend,” and it rings very true in my head, I’m determined to change that mindset. I despise working for the weekend, and long for the day I can spend working on a garden or home that I’ve built with my own hands and sweat and labor. I long to be self sufficient in supporting my own family without being a corporate slave. Don’t get me wrong, I love what I do and who I work with, it’s just the idea of doing this until I retire at 55, 65 or 75, before I can start enjoying life and seeing the world in retirement.

What do I mean when I say self sufficient? I mean living off of the land and working for myself, my family, and my community. To not have my family’s survival tied to my ability to keep a corporate job. To produce what my family would consume in my own garden and through having our own animals, trading for certain goods or services we don’t have.

Is it possible to buy a piece of land and produce my own food to raise a family and live well? What would it take to do so? Would I need several acres of land or several hundred. What kind of home would I have to build? How much would all of this cost? Would I be able to home school my kids? Would this be detrimental to their well being and would they despise me as they grew older? and finally, would my wife even go for something like this?

Over the next several weeks and months I’m going to look and find people who have done just this, and see what they feel are the ups and downs and if they would do it all over again if they were able to choose to do so. In particular, I have an uncle that moved his family away from the city to the country. I’m going to try and get his views (and his wife and kids) on this and try and find others to share their story. I’m going to hone in on the viability of making the move and home much money you would need to have stashed to do so. I’m hoping to one day make this a reality, even if it means doing so when I’m 50 and my kids have moved out. I hope you’ll join me and share your story or put me in contact with anyone else who has already done so.

Please, tell me your thoughts and specific questions you may have so I can ask them.

It’s time to get the heck out of bonds, there’s a bubble about to pop

I’ve spoken before about my portfolio being about 92% stock (mutual funds, etc.) and about 8% bonds. A couple of days ago, I decided it was time to make a change and get out of bonds. Below, I will tell you why you should consider doing the same.

Before you consider doing what I’ve done you must understand that what you should do depends on your age, risk tolerance, and a multitude of other factors. For me, in my early 30’s, I’ve got 30 or more years of investing in the market left. Having said that, I’m of the belief that I should be as risky as possible right now as long as I remain diversified. Although bonds are a way to preserve capital, or preserve it in times of major market declines, when markets are bullish you’re probably losing money in bonds to inflation.

With the above disclaimer out of the way, now I’ll speak to why I’ve gotten rid of virtually all of my bond holdings. First off, as mentioned, I wanted to take more risks, the paltry returns on my bonds do not provide enough incentive for me to keep them. I would rather take more risks for the opportunity to get more in return for my investments. I’ve shifted those bond dollars into value and growth stocks. Secondly, I, like many others feel there is a major bubble brewing in the bond markets as so many people flocked to bonds in the past year or two. We’re recently been experiencing deflation as a result of many factors including unemployment and in turn lower consumer demand. However, as the economy turns around and companies begin making a profit again, inflation is inevitable. Once inflation creeps in, investors holding bonds will be hurt and most probably don’t even know it.

This Wall Street journal piece summarizes this predicament quite well:

“If yields are low, like now, and inflation takes off you can get into trouble. Those who invested in long-term Treasury bonds in the mid-1960s, just before inflation surged, actually lost money in real terms over the following 20 years. (Those who bought bonds in the early 1980s, when yields went as high as 15%, made out like bandits as inflation collapsed.)

When inflation rises the government usually raises short-term interest rates. And that’s an additional problem for bondholders. When short-term savings accounts are paying about 1% a year, a piece of paper from a company promising 3.8% a year for 10 years can look quite valuable. But it’ll be worth a lot less if short-term rates were to rise to, say, 5%, or even more.

Are we definitely in a bond bubble? Even though prices seem high, it’s not certain. Some people argue that they are a reasonable value, and inflation will stay subdued. Indeed one or two bearish strategists argue bonds could go even higher, and yields lower. Only time will tell.

There are very few certainties in the financial markets. For private investors, the key is to make sure you’re getting paid for the risks you’re taking. In the case of anyone holding long-term bonds, you’re probably not.

Now you’re asking yourself “Well, what should I do”? Once again, that same wall street journal article summarizes some very practical tips to help combat this problem:

What can you do about it? Here are three practical steps to take if you are worried:

1 Limit your exposure to very long-term bonds. These are the ones most at risk from rising inflation and interest rates. Most people invest in bonds through mutual funds that have a mix of short-, medium- and long-term bonds.

How does your fund stack up? Just check the duration. That’s a technical term that’s the best measure of a bond’s inflation and interest-rate risk. Longer-term bonds have longer durations. The fund company will post this number, usually on the monthly fact sheet on its Web site.

A short-term fund will usually have a duration of a few years. You will earn less money in short-term bonds, but you will face fewer risks. A fund with a duration beyond about six to seven years is taking on more risk.

2 Move some bond money into TIPS. Treasury Inflation-Protected Securities are bonds with built-in inflation protection. Right now, the 20-year TIPS bond promises to pay about 2% a year on top of inflation. By historic standards it’s not steal — but it’s OK.

It offers a much better tradeoff between risk and reward than the regular long-term bonds. And it lets you sleep easy at night. With TIPS, you no longer have to worry about inflation. Bond prices can still move, but rarely by much — and if you hold the bond for 20 years, it doesn’t matter at all.

3 Consider some dividend stocks as well. Too many investors think in simplistic silos — stocks are risky, bonds are safe, and so on. Yet stocks of many solid, blue-chip companies may prove very safe investments, especially if you buy a basket of them, and you buy them when they are cheap. (Meanwhile, bonds may prove very risky, especially if you buy them when they are expensive.)

Over time, stocks also have typically offered better protection against inflation than bonds.

You can find plenty of decent yields without going near the high-risk financials. Take these exchange-traded funds: The Vanguard Consumer Staples ETF, which invests in such companies as Procter & Gamble, Wal-Mart Stores, Philip Morris International and Kraft, has a dividend yield of 2.6%. The Vanguard Telecommunications Services ETF is yielding 3.8%, and the Vanguard Utilities ETF, 4%.

Do your homework and understand what you’re owning, but many blue-chip stocks with good yields can be a good addition to an income portfolio.